Banks Take Hidden Subprime Path

April 10, 2018

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These
days, Wells FargoWFC -0.45% &
Co. and Citigroup Inc. C -0.47% are
unlikely to make a $14,000 auto loan to a borrower with a subprime credit
score. That is now the domain of direct lenders such as Exeter Finance LLC,
based in Irving, Texas.

But where does Exeter get the money to make subprime auto loans? From
Wells Fargo and Citigroup. They have helped lend Exeter $1.4 billion for that
very purpose.

Bank loans to Exeter
and other nonbank financial firms have increased sixfold between 2010 and 2017
to a record high of nearly $345 billion, according to a Wall Street Journal
analysis of regulatory filings. They are now one of the largest categories of
bank loans to companies.

Banks say their new approach of lending to
the nonbank lenders is safer than dealing directly with consumers with bad
credit and companies with shaky balance sheets. Yet the relationships mean that
banks are still deeply intertwined with the riskier loans they say they swore
off after the financial crisis.

Loans to nonbank lenders got several banks into trouble during the crisis. Montgomery, Ala.-based Colonial Bank, for instance, became one of the largest bank failures of the era after a
nonbank mortgage lender misappropriated more than $1.4 billion from its credit
facility with the bank, according to the Justice Department.

During the housing boom, banks thought they
had unloaded the risk of subprime mortgages to other institutions through
collateralized debt obligations or vehicles known as conduits. Yet in the
stress of the crisis, they found the risk landed back with them.

“It’s very easy for
people to deceive themselves over whether risk has migrated,” said Marcus
Stanley, policy director at Americans for Financial Reform, a nonprofit
organization that advocates for tougher financial regulation.

Banks say that this
time around they have figured out how to structure the credits to avoid
problems.

The money still ends up with people with poor
credit. The typical Exeter customer, for example, has a FICO score of around
570 on a range of 300 to 850. (Anything below 600 is usually considered
subprime.) Exeter, which is majority owned by private-equity firm Blackstone Group LP,
charged off about 9% of its loans as of September 2017, according to S&P
Global, compared with 1% for Wells Fargo’s auto loans.

Exeter Chief
Executive Jason Grubb said his firm has had “consistently strong credit
performance” and that the structure of the loan to his firm means “the banks
are well protected.”

The nonbanks turn a profit by charging
borrowers a higher rate—say, 15% on a subprime auto loan—than what they pay to
the bank, which might be 3%. The bank makes money on that 3% loan because it is
funded by deposits, on which it pays almost nothing.

Exeter has tapped the $1.4 billion line of
credit to extend billions of dollars of loans since its 2006 founding. Barclays PLC
and Deutsche Bank AG joined
Wells Fargo and Citigroup to provide the facility. It eventually bundles its
loans into securities and sells them to private investors, using the proceeds
to pay back the banks, in addition to paying them fees.

Years ago, the typical subprime-auto customer
might have been able to get a loan directly from Wells Fargo or Citigroup.
Wells Fargo closed its subprime-lending subsidiary in 2010 and dialed back from auto lending more broadly in 2016.
Citigroup sold much of its auto lending unit.

Wells Fargo, however, has continued to extend more credit to nonbank financial
firms—it counted $81 billion of these loans at the end of 2017, the largest of
any bank, compared with $14 billion at the end of 2010.

By 2016, loans to
nonbanks grew to the fourth-largest category of bank lending to companies, up
from the 11th in 2012. Around that time, officials from the Office of the
Comptroller of the Currency reviewed the exposure at more than a dozen banks,
according to a person familiar with the matter.

The regulators looked at the types of
nonbanks the banks were lending to, whether those loans were properly secured
by collateral and whether there were any concentrations of risk, the person
said. At the time, the OCC found the exposure manageable.

Typically, banks
require the nonbanks to commit the loans they make as collateral for the bank
loan. And they will only lend the nonbanks an amount equivalent to a portion of
the collateral—meaning a much higher-than-expected share of the loans would
have to go bad for the bank to lose money.

Still, no loans are risk-free. About two
years ago, for instance, falling energy prices forced banks to put aside billions of dollars in reserves in case
loans to oil-and-gas companies went bad, even though they were largely well
secured. Eventually, energy prices rose and banks faced fewer losses than
expected. But banks had to pull back from lending to the sector.

For now, bank credit
is even flowing to areas where it collapsed after the financial crisis, such as
loans to mortgage lenders. In 2016, for the first time in more than 30 years,
nonbank lenders accounted for the majority of mortgage dollars extended to borrowers.

Mortgage lender
loanDepot Inc. said in a 2015 regulatory filing that its business prospects
were bright because “banks and other traditional market participants continue
to be ineffective in adequately addressing consumer needs.”

But
loanDepot also disclosed in its filing that it was flush with money to make new
loans, in part because it had a $250 million line of credit from Bank of America Corp. It
has also opened credit facilities with regional and foreign banks.

A Bank of America
spokesman said that the bank limits its subprime exposure in line with its
approach to responsible growth.

“It is the lifeblood
of how we fund our customers,” said Bryan Sullivan, loanDepot’s finance chief.